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How To Tell If Your Startup Is Ready For Venture Financing

The following guest post is by Jeff Thermond, a Venture Partner at XSeed Capital involved in Information Technology and computer networking.

Jeff Thermond

So you’ve got a great idea for a new startup. Congratulations! Before you begin, you might want to think twice about the scope of your great idea.

Put simply, the question is whether your great idea is a feature, a complete company, or something in between? The question may seem to be just a detail or completely unnecessary, but to potential investors, it will be top of mind as they first hear your pitch. And the answer they come up with may put you out of the running before you even get to your fifth slide. Allow me to elaborate:

A little known fact about startups is that most don’t fit the profile for venture financing. The investors in venture know that the success rate for venture-financed companies is low, which means that the successes in the asset class which occur have to make big returns in order to both make up for the companies which did not make it, as well as to earn returns commensurate with the risk of the asset class. The implication of that is that investors feel that every investment they make has to be capable of “returning the fund” or some variation of that very high bar. The second implication is that venture investors often pass on really good ideas because they don’t believe the idea can produce explosive returns.

Perhaps surprisingly, insufficient scope has a parallel at the opposite end of the scale spectrum: Too much scope can also be an issue. This can happen because the venture community by and large has moved on from certain more capital intensive areas where it used to make a lot of money because these areas now require so much capital, they can almost never produce outsized returns on that large amount of capital. My first startup, a semiconductor company, exited in less than three years for half a billion dollars on less than $17 million in venture capital. A very similar competitor sold to Qualcomm a few years later for almost $200 million. However, the company had consumed as much as it took in, and the investment was dead money. Once semiconductors became very capital intensive, they moved into the ‘too much scope’ category and stopped being a business model most firms thought they could make money off of.

So, what does this have to do with the scope of your great idea? Everything.

Say you’re like me, and you can’t figure out how to run a sales operation without some CRM tool such as SalesForce, but you’re disappointed with the tool’s ability to generate meaningful reports easily. You might decide that it would be a great idea to start a software company which would let you easily create a mobile app which would allow sales people to see their pipeline at each stage in parallel with all the other peers of the sales person. This software would be the same as how a sales manager would look at his team’s performance, and it would probably inform a sales person as to how his next conversation with his manager would go. Sales people might adopt this software in droves in order to be better informed, and customer adoption might go viral. The company could be a raging success.

Well, maybe. This kind of idea hews to the ‘feature’ side of the discussion above and illustrates two problems with ‘feature only’ companies.

Firstly, the idea does not have technical differentiation. There are many ways to generate reports out of a database and people have been doing this for decades. That means many people know how to write the code to create this feature, and the product can be easily copied. If this company had compensating factors such as vendor lock-in or network effect, it could potentially make up for lack of technical differentiation. However, this is a mobile application which does not store or create its own data. It can be copied quickly.

Secondly, since the product can be copied easily, there is the high probability of low ASPs for two reasons: many potential competitors might emerge quickly, which almost always engenders a race to the bottom in pricing. In addition, customers will likely be reluctant to pay a high price for something which is limited in functionality.

Notice, however, that this is still a good idea; it’s just not a good venture idea. It can’t produce explosive returns and it isn’t differentiated enough to protect its success from inevitable competitors.

Another area that venture has stepped away from is custom hardware, especially big metal hardware with custom ASICs. (That would be my second startup, which failed.) These ideas certainly have the scope to be full companies, even ones capable of an IPO. However, they require well over $100 million to capitalize fully to an exit. There is great doubt in the venture community that the returns from multi-hundred million dollar investments in startups building custom hardware are going to match the expectations of any fund’s investors.

Given the above, the scope of your idea matters a great deal. Too small an idea means copycat competitors, race to the bottom pricing, and a company which (at best) may throw off a few million dollars a year of profits but will not produce a big pop for the investors in a short period of time. Too big an idea may require so much capital that the return on the capital can never make up for the riskiness of the asset class.

I think the sweet spot for scope (there are many paths to a sweet spot exit for a startup; this article is about the sweet spot for scope) is a company with strong technical differentiation that attacks a large opportunity in a market that has proven its willingness to consider new ideas, products or services. Furthermore, I think the sweet spot for scope is built around the scope of the product where the entrepreneur can get a Minimum Viable Product (MVP) to market quickly and revise the product or pivot quickly if circumstances dictate.

So how is that any different from the “feature” scope, which I argued can be too limited? After all, features can be brought to market very quickly, they can be deployed against a significant pain point, and they certainly can be revised quickly.

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